Prudential Regulations

• Dowd (1996): 'If nothing is wrong with it, the whole panoply of government intervention into the financial sector - the central bank, government-sponsored deposit insurance and government regulation of the financial system – should presumably all be abolished'
• Financial laissez-faire (free market)


  The argument that if free trade is generally desirable, then what is wrong with free trade in the financial services sector
• In an 'imperfect' economic environment (e.g. where information is scarce and asymmetric)

  Privately-operated financial intermediaries can achieve superior outcomes without government intervention
• If the good banks felt there was a danger of contagion

  They would take appropriate action – they would strengthen themselves and curtail credit to weak banks to help ensure that contagion did not in fact occur
• Dowd (1996) argues that


  With no lender of last resort or state-run deposit insurance system, depositors would be acutely aware that they stood to lose their deposits if their bank failed, so they would want reassurance that their funds were safe and would soon close their accounts if they felt there was any significant danger of their bank failing
• Bank managers would understand that their long-term survival depended on their ability to retain their depositors' confidence


  They would therefore pursue conservative lending policies, submit themselves to outside scrutiny, and publish audited accounts. They would also provide reassurance by maintaining adequate capital
• If the bank's capital is large enough, if the bank is adequately capitalized

  The bank can absorb any plausible losses and still repay depositors, and depositors can be confident that their funds are safe
• Competitive pressure produces instability


  This happens when bad banks expand rapidly, good banks are forced to follow, and this undermines the financial system
• A bank can only expand rapidly by allowing the average quality of its loan to deteriorate

  Major deterioration of loan quality will undermine its long run viability and consumer confidence
• If a bank believes that its competitors are undermining themselves

  They will distance themselves and build up financial confidence to take the bad banks customers and market share when it fails
• When bad banks are in trouble

  People will remove their money and prevent a calamity within the system
• Instead of contagion


  We would expect the difficulties of a weak bank to trigger a flight to quality in which customers transfer their accounts to stronger banks
• Lender of Last Resort (CB)


  This provides liquidity to banks that otherwise could not afford it
• Lender of Last Resort


  Only protects bad banks from their actions by encouraging them to do greater risk taking and maintain weaker capital positions that good banks will avoid. Since it protects bad banks it also reduces the incentives of good banks to build themselves up in response to bad banks
• Deposit Insurance


  This reduces the incentives of individuals to monitor banks and also for managers to maintain confidence of customers
• A bank's rational response to deposit insurance

  Is to reduce its capital (since this is important to maintain confidence they no longer are striving to keep)
• Even if the good banks wanted to maintain capital

  They would be out competed by bad banks who hold lower capital and offer higher interest rates to depositors
• Deposit insurance


  Transforms a strong capital position to that of competitive liability, reduces financial health, and makes them more likely to fail. Banks operate at the margin, with greater risk taking, and if it pays off it is held as profit but it fails the cost is passed on to the deposit insurance
• Government intervention in the financial sector only serves to protect bad banks from the consequences of their own actions, and reduces the incentives for good banks to adopt the virtuous strategy of building themselves up in anticipation of winning weaker banks' market share
• Several cross country studies have found a link between financial liberalization and financial sector crisis
• Recent experience has demonstrated that financial crisis can be highly damaging for economies, government budgets and living standards
• Objective of prudential regulation

  To protect the stability of the financial system and protect depositors, so its main focus is on the safety and soundness of the banking system and on non-bank financial institutions that take deposits
• Policy justification for prudential regulation and supervision

  To prevent systemic risk and to provide protection for small depositors. Banks are subject to moral hazard and adverse selection which can put their depositors at risk
• The numerous bank depositors do not have the incentives to monitor banks optimally because of free rider problems and also lack the expertise to do so
• The information that is normally available to depositors is usually inadequate to correctly assess the risks which the financial institution is facing
• During the past two decades many developing countries have sought to liberalize their financial systems, and this period has also seen a significant increase in financial fragility, with widespread financial distress afflicting banks and non-bank institutions in many developing countries during the 1980s and 1990s
• As financial markets are liberalized, sound financial regulation and supervision are needed to protect the stability of the financial institutions
• Most LDCs are yet to create such systems of financial regulation and supervision. Where they have, they are not properly or fully implemented or they have adopted systems fashioned in DC that are not suited to the unique characteristics of LDCs (legal and accounting systems are weak, acute shortage of skilled personnel to undertake supervision, and regulators are vulnerable to political interference)
• Banking sector crisis is more likely to occur when the macroeconomic variables are weak
• Capital Adequacy Requirements


  Capital requirements are at the centre of prudential regulatory requirements and have a dual role: 1) It provides a buffer against unanticipated losses, which might otherwise render the bank insolvent and lead it to default on its obligations to its creditors, 2) Capital enhances incentives on owners for prudent bank management
• A bank's stated capital position is virtually meaningless in the absence of proper accounting procedure which ensure that appropriate provisions are made for non-performing loans and that bad debts are written off
• Minimum Cash Reserve and Liquid Asset Ratios

  The ratios are often imposed on banks to provide some protection against illiquidity
• Restrictions on Asset Portfolio Choices and Risky Activities

  These include restrictions on large loan exposures, inside lending, foreign exchange exposures, investment in equity and undertaking of non-banking activities
• Such measures will, however, be ineffective in controlling risk unless banks are properly supervised and prudential regulation enforced
• Disclosure Standards


  Requirements to publish audited accounts can be seen as attempts to mitigate informational problems and to reduce the scope for hidden activities
• Before the 1980's, LDCs did not accord a high priority to the prudential regulation and supervision of their financial system (government policy emphasized regulation or banks were foreign own and subjected to regulation from parent companies)
• The fragility which emerged in the financial systems of many LDCs in the 1980s exposed the inadequacy of their prudential system in the face of changes to the structure of their financial system
• LDCs had understaffed supervisory departments, enforced economic regulations not prudential ones, had banking laws that were outdated (minimum capital requirement eroded by inflation), and state owned FIs were not subjected to banking laws or supervision
• An industrial country model of regulation and supervision has been adopted by most LDCs, based on the Basel Committee's Core Principles for Effective Banking Supervision
• The model involves a set of detailed prudential regulations, with supervision undertaken directly by a public agency